Tax conformity of earnings and the pricing of accruals

• Published in: Review of quantitative finance and accounting Vol. 40; no. 3; pp. 509 - 538
• Main Authors: Báez-Díaz, Aníbal, Alam, Pervaiz
• Format: Journal Article
• Language: English
• Published: Boston Springer US 01-04-2013; Springer Nature B.V
• Subjects: Accounting/Auditing; Conformity; Corporate Finance; Decomposition; Deferred income taxes; Earnings; Econometrics; Economics and Finance; Finance; Hedging; Income shifting; Investments; Market prices; Operations Research/Decision Theory; Original Research; Portfolio analysis; Pricing; Securities markets; Statistical analysis; Tax increases; Tax shelters; Tax systems; Taxable income; Accrual mispricing; M41; Nondiscretionary accruals; Discretionary accruals; Tax conformity
• ISSN: 0924-865X; 1573-7179
• DOI: 10.1007/s11156-012-0275-2

The primary purpose of this study is to investigate whether the market prices discretionary and non-discretionary tax accruals. Previous studies have examined the persistence of total accruals (Sloan in Account Rev 71(3):289–315,
1996
) and the persistence of discretionary and non-discretionary components of total accruals (Xie in Account Rev 76(3):357–373,
2001
). These studies do not investigate the tax components of accruals. We argue that tax accruals are mispriced more than book accruals because of the complexity of tax accruals in assessing future earnings. We use a sample of 6,397 firms and the Mishkin model to investigate whether the market overvalues tax accruals more than book accruals. Descriptive statistics show that firms are increasingly using more income decreasing tax accruals than income-increasing book accruals contributing to the growing divergence between tax and book earnings. Results from the Mishkin test show that the overpricing of tax accruals is more severe than that for book accruals. Finally, hedge portfolio tests show that investors can earn excess returns using a hedging strategy based on tax accruals. Interestingly, excess returns based on a hedging strategy using book accruals almost disappear.